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May 2, 2012

How to Detect if Your Fund Manager Is a ‘Closet Indexer’

R-squared is a quick way to judge whether an actively managed fund tracks its benchmark too closely

Knowing a fund’s R-squared number can help advisors determine whether the higher cost of an actively managed fund versus an ETF is worth the extra investment dollars.

R-squared, a measure that shows how much a fund moves in sync with an index, is a quick way for an advisor to compare an actively managed fund with an exchange-traded fund that makes no secret of index tracking. Knowing a fund’s R-squared number can help advisors determine whether the higher cost of an actively managed fund versus an ETF is worth the extra investment dollars.

For example, the S&P 500 index has an R-squared of 1.00 because its movements rise and fall in sync with the S&P 500 100% of the time. This suggests that an actively managed large-cap equity mutual fund whose R-squared approaches 1.00 is unlikely to be a good value, considering how much more cheaply an advisor can purchase similar shares in an ETF.

“Active managers can become too index fund-like, and therefore you’re paying fees for a closet indexer,” said Howard Present, president and chief executive of F-Squared Investments, Newton, Mass., which saw more than $4 billion in net inflows for 2011. “It’s safe to say no one has ever accused us of being a closet indexer because we have the ability to change the profile of the portfolio a lot, which we do. Certainly, in 2008, when we were 50% in cash and the only two active sectors we had were Consumer Staples and Utilities, it didn’t look like the S&P 500.”

F-Squared serves as investment manager for the Virtus Premium AlphaSector Fund (VAPAX), launched in 2011, using Select Sector SPDR ETFs as the basis of a strategy that invests in long-only U.S. equities and short-term Treasuries. VAPAX has a relatively low R-squared of 0.696. In comparison, the storied Fidelity Magellan (FMAGX) has an R-squared of about 0.91.

In an April 9 note, S&P Capital IQ noted that all funds use a benchmark index to track their relative performance, and the fund manager’s compensation often depends on the fund beating its benchmark. But active fund managers risk taking this concept too far by attempting to mirror its index, S&P Capital IQ warns.

“In our view, one of the primary functions that an actively managed mutual fund portfolio manager serves is to add value by differentiating him or herself from their respective benchmark index,” wrote the S&P Capital IQ equity analyst Michael Souers in a note for Standard & Poor’s MarketScope Advisor. “There are too many low-cost products, ETFs and index funds, that can track the index closely, so why would an investor pay the relatively higher expense ratio of an actively managed fund to achieve virtually identical returns?”

‘A Good Argument to Avoid a Large-Cap Active Fund if the Expense Ratio Is High’

When asked in a phone interview with AdvisorOne what a “good” R-squared number might be, Souers said it depends. For equity funds that track large-cap companies, it’s hard to stray too far from the S&P 500, but small-cap stocks don’t correlate as much, so they’re likely to have a lower R-squared. That said, anything below an R-squared of 0.85 may be considered a low number, he said.

“It’s a good argument to avoid a large-cap active fund if the expense ratio is high or the fund has loads,” Souers concluded. “The compensation of a portfolio manager of an actively managed fund is so closely tied to beating a benchmark. That whole scenarios lends itself to less risk taking. If they have a bad year and they underperform the benchmark by 400 or 500 basis points, they worry that their job is at risk.”

In his note, Souers pegged the Thrivent Large Cap Stock Fund (AALGX) as having the highest R-squared, at 0.99, of any of the funds that met all of his screening criteria.

“As one might expect, the fund's top-10 holdings include widely held names such as JPMorgan Chase, Wells Fargo and Amazon.com,” Souers wrote. “AALGX holds what we view as a substantial 123 stocks in its portfolio. AALGX has underperformed its Large Cap Core peers over the past one-year, three-year, five-year and 10-year periods, with a 350 basis point underperformance over the one-year period (0.9% versus 4.4%). While the fund's expense ratio is below peers (1.1% vs. 1.2%), it is well above the expense ratio of most index funds and ETFs.”

Company officials at Thrivent did not respond to requests for comment.

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